Canadian roundup: FAS 125 Embraced by Canadian Market

The introduction of a Financial Accounting Standards 125 equivalent in Canada will open up the market for the securitization of riskier assets - which include defaulted assets like charged-off credit card receivables as well as longer-term assets such as commercial mortgage-backed securities.

It will also harmonize accounting rules in Canada with those in the U.S. and other parts of the globe, potentially increasing the volume of Canadian securitizations, experts said.

One of the ways in which the new accounting rules will allow for more securitizations going forward is by helping reduce the tax liability of the seller.

Currently, the Canadian federal government and a number of provinces are imposing capital tax on the debt and equity portion of a company's balance sheet. This tax liability may be significantly reduced if the income from the securitization is kept off balance sheet and used to repay debt.

The problem is the current standard, which was implemented in 1989 as a temporary measure, only considers a securitization as a sale if the significant risks and rewards of ownership are passed on to the purchaser (see Observation 2/14/00).

"Under the new rules, the risks and rewards do not matter anymore, what matters is the purchaser's control over the assets," said Andre de Haan, of Ernst & Young securitization practice in Canada.

Aside from making it easier for transactions to be considered a sale, the elimination of the risk and reward model also opens up transactions to new possibilities.

"You couldn't have swaps, puts or other types of derivatives that gave a non-standard return to the seller of the assets," added de Haan.

However, under the new rules, the return to the vendor doesn't affect whether the transaction is a sale. As a consequence, most of these things can be put into deals. "All this means is we should see more transactions that are tailored to what the vendors really want from their securitization," he added.

Unlimited Recourse

Another benefit of the introduction of the new standard will be the elimination of the current limited recourse rule. Under the current rules, a seller is only entitled to retain a "reasonable" amount of recourse, such as recourse that is not more than three to four times the historical losses or more than 10% of the the transaction's proceeds.

The new rule will have no limit on the amount of seller recourse, and this should make cost-effective securitizion available for a company's strong portfolios (having, say, losses of 1%) which would require more recourse than the 3% or 4% that such company is currently permitted to provide, said Martin Fingerhut, a partner at Blake, Cassels & Graydon LLP.

He added that challenging portfolios with significant losses will also benefit since the seller will be able to stand behind more than the current 10% limit.

Moreover, the unlimited recourse may also allow new asset classes to enter the Canadian asset-backed market and it should be easier for smaller players to complete transactions because there would be less need for credit enhancement under the new rules.

"Under the current rules, the arbitrary limit on recourse meant that the companies would often have to find a third party credit enhancer to provide the additional layer of recourse demanded by the market," de Haan said. "I think that since we are not going to have that limit anymore, you won't see as many companies going to third party credit enhancers unless there's a compelling economic reason for doing so."

Though structuring a deal under the new accounting rules may prove to be more complicated, the elimination of the 10% cap is a big positive.

"Under the new guideline, there's a lot of little rules but they are not as fundamental to the transaction," stated de Haan. "The 10% cap is an economic fact. If the assets have an expected loss greater than 10%, you likely couldn't get a transaction done at all. Now it will be more a matter of structuring the transaction appropriately to fit the rules."

The Complexities

Under the new rules, companies would have to approach gain-on-sale accounting differently.

Fingerhut said that sellers will for the first time be required to record the gain or loss on the sale of their securitized assets, which will be contrary to the approach currently followed by many companies, and may be perceived as being overly aggressive.

Moreover, in the current guideline, an all or nothing approach is used to determine the amount of the gain-on-sale; everything the vendor got back after a sale is recorded at fair value. In some cases, gains are deffered. On the other hand, under the new rules, the component approach will be followed where all the pieces that were sold are recorded at fair value while retained assets will continue to be recorded.

"You have to record on your balance sheet all the individual derivatives and other assets and liabilities created by the securitization transaction," said de Haan. "It's going to be more complicated than it used to be because figuring out the individual fair values of these items is not going to be as straightforward as figuring out one single net receivable from the securitization trust."

"The deal execution in a micro-sense is more difficult because you have to look at all the rules and go through the transaction step by step," de Haan added.

The new gain-on-sale accounting method may cause companies to record a bigger profit margin, likely to make them maintain a more regular securitization schedule.

Also, because of the more complex transactions, Fingerhut said that this should give accountants a greater role both before and after the transaction and may create tension between the company's treasury personnel and its accountants.

Congruence with the U.S.

The new guideline would allow for more securitizations for Canadian subsidiaries both in Canada and cross-border.

"If the U.S. parent wishes off-balance-sheet treatment for the Canadian securitization on its consolidated statements, and if the Canadian subsidiary also wants off-balance treatment on its own financial statements, the transaction has to be structured to comply with the accounting standards of both countries," said Fingerhut. "This has sometimes resulted in significant hurdles. Now that the two standards will be substantially the same, this difficulty will be eliminated."

The timing for completion of the new Canadian accounting standard is dependent on when the U.S. Financial Accounting Standards Board (FASB) finishes its version of the revised U.S. standard, which is expected by Sept. 30, said Peter Martin, principal at the Canadian Institute of Chartered Accountants.

The CICA has prepared its own draft of material using extracts from the FASB exposure draft of amendments to FASB Statement 125 published in the middle of last year.

"We're currently waiting to see the text of the revised U.S. standard," said Martin. "Since we are trying to harmonize with their end result, we have to know what it is before we can finish."

He added that if the FASB publishes its standard by Sept. 30 there's a possibility that the Canadian Accounting Standards Board could approve the material by the end of this year. But following Board approval, it takes a little while before the CICA can complete the publication processes so the CICA wouldn't be able to issue the standard until shortly after the end of 2000.

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